Industrial Policy and Regional Trade Agreements

This study examines whether regional trade agreements (RTAs), such as free trade agreements (FTAs) and customs unions (CUs), facilitate or hinder the achievement of multilateral trade liberalization when governments implement industrial policies. We develop a symmetric three-country model of international oligopoly with endogenously determined tariffs and production subsidies and consider not only RTAs, where member countries independently determine their production subsidies, but also deep RTAs, where member countries harmonize production subsidies. We show that forming an FTA or CU, with or without harmonizing production subsidies, improves the welfare of all member and non-member countries. More importantly, FTAs, regardless of whether production subsidies are harmonized among member countries, will prevent multilateral trade liberalization. Furthermore, if member countries harmonize production subsidies, CUs act as building blocks for multilateral free trade; otherwise, they serve as stumbling blocks. This is in sharp contrast to the results of traditional models with tariffs alone, where given three symmetric countries, both FTAs and CUs tend to facilitate multilateral free trade.